Friday, January 30, 2015

HCP Inc (HCP) A High Yield REIT Play on Healthcare

HCP, Inc. (HCP) is an independent hybrid real estate investment trust. The fund invests in real estate markets of the United States. It primarily invests in properties serving the healthcare industry including sectors of healthcare such as senior housing, life science, medical office, hospital and skilled nursing.

HCP is a dividend champion which has increased dividends for 30 years in a row. The latest dividend increase was in January 2015 , when the board of directors increased the distribution by 3.87% to 56.50 cents/share.

Over the past decade, FFO/share has increased from $1.64 in 2003 to an expected $3.10 in 2014. This comes out to an annual FFO increase of 5.90%/year on average.

The company operates under 5 segments. Senior housing contributes 37% of revenues in 2013, while Post-Acute/Skilled properties contributes 31% of revenues. The Life Science and Medical Office Segments contributed 14% and 13% respectively, while the remaining 5% is generated from Hospital properties. I also like to look at the tenant diversification, in order to determine if revenues are overly dependent on a single customer. Based on the 2013 annual report, the four largest customers were HCR Manor Care with 29% of revenues, Emeritus Corporation with 13% of total revenues, Brookdale Senior Living with 8% and Sunrise Senior Living with 5%. The leases often provide for either fixed increases in base rents or indexed escalators, based on the Consumer Price Index or other measures, and/or additional rent based on increases in the tenants’ operating revenues. Most of our the leases require the tenant to pay a share of property operating costs such as real estate taxes, insurance and utilities. Substantially all of HCP’s senior housing, life
science, post-acute/skilled nursing and hospital leases require the operator or tenant to pay all of the property operating costs or reimburse us for all such costs. The statistic to use is same-store growth, which has consistently been above 3% since 2009, and ranged between a low of 3.10% in 2013 to a high of 4.80% in 2010.

FFO/share growth has definitely been helped out by the low cost of debt, which has also been decreasing throughout its life as a public company since 1985. The nice thing about its debt profile is that almost all of liabilities are with fixed interest rates. Approximately half of the debt matures by 2018, which would mean that it would have to be refinanced at the rates available at the moment. The risk of course is if those rates start going up, it could leave less money for acquisitions and growing distributions.

Another factor that has helped FFO/share growth is the acquisition of properties, as well as strategic debt investments it has made. As the population ages in the US, the demand for health care services is only expected to increase. The percentage of senior citizen population is estimated to increase over the next 30 – 40 years, as is the growth in healthcare services. Therefore, a company like HCP should be able to enjoy stable occupancy in its medical properties, and recurring rents from that diversified portfolio that grow over time.

Over the past decade, dividends per share have increased from $1.66 in 2003 to $2.18 in 2014. This comes out to an annual dividend increase of 2.70%/year on average. The company offers a drip discount of 1% for those shareholders who elect to reinvest distributions back into more HCP shares. As a REIT, the company is required by law to distribute at least 90% of its taxable income. Since it is not taxed at the entity level, most distributions are not eligible for the preferential qualified dividend tax rates. Instead, a large portion of distributions are usually taxed under the ordinary income tax rates. The percentage allocations by tax source vary each year however. For example, in 2013, approximately 86% of the distribution was treated as ordinary income for tax purposes, while 7% was treated as capital gains income and the remainder was treated as a return of capital, which is nontaxable but reduces shareholders’ basis in the stock.

The reason behind the slower dividend growth relative to the higher FFO growth is due to the steady decrease in the FFO payout ratio over the past decade. Back in 2003, this indicator stood at 99%, which was certainly unsustainable. However as of 2014 it stands at 70%. The company also has another indicator called Funds Available for Distribution, which stood at $2.52/share in 2013. Therefore the dividend is well covered, and also has potential for growth at close to the rate of inflation for the foreseeable future.

HCP is an investment for those who need current income today, which will at least match the rate of inflation. I believe that the income stream is defensible, which means that dividends are secure, and are very likely to continue growing at least by the historical rate of annual inflation of around 3% over the next decade. As a result, the lower the entry price paid by the investor, the better the chances for higher returns, especially since the majority (approximately 60%) of long-term returns for REIT investors come from their distributions. The shares currently yield less than 5% and are selling for a forward price/FFO ratio of 15.40. I recently initiated a small position in HCP Inc. However, I would like to build a position in this REIT at an entry yield of 5 - 5.50% or higher.

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